Chapter 8 NAM�---------

Slutsky Equation

Introduction. It is useful to ·think of a price change as having two dis­

tinct effects, a substitution effect and an income effect. The substitution
effect of a price change is the change that would have happened if in­
come changed at the same time, in such a way that the consumer could
exactly afford her old consumption bundle. The rest of the change in the
consumer's demand is called the income effect. Why do we bother with
breaking a real change into the sum of two hypothetical changes? Because
we know things about the pieces that we wouldn't know about the whole
without taking it apart. In particular, we know that the substitution ef­
fect of increasing the price of a good must reduce the demand for it. We
also know that the income effect of an increase in the price of a good is
equivalent to the effect of a loss of income. Therefore if the good whose
price has risen is a normal good, then both the income and substitution
effect operate to reduce demand. But if the good is an inferior good,
income and substitution effects act in opposite directions.
Example: A consumer has the utility function U(x 1, x2) = x1x2 and an
income of $24. Initially the price of good 1 was $1 and the price of good 2
was $2. Then the price of good 2 rose to $3 and the price of good 1 stayed
at $1. Using the methods you learned in Chapters 5 and 6, you will find
that this consumer's demand function for good 1 is D1 (P1,P2,m) = m/2p1
and her demand function for good 2 is D2(P1,P2, m) = m/2p2. Therefore
initially she will demand 12 units of good 1 and 6 units of good 2. If,
when the price of good 2 rose to $3, her income had changed enough so
that she could exactly afford her old bundle, her new income would have
to be (1 x 12) + (3 x 6) = $30. At an income of $30, at the new prices, she
would demand D2(1,3,30) = 5 units of good 2. Before the change she
bought 6 units of 2, so the substitution effect of the price change on her
demand for good 2 is 5 - 6 = -1 units. Our consumer's income didn't
really change. Her income stayed at $24. Her actual demand for good 2
after the price change was D2(1,3,24) = 4. The difference between what
she actually demanded after the price change and what she would have
demanded if her income had changed to let her just afford the old bundle
is the income effect. In this case the income effect is 4 - 5 = -1 units
of good 2. Notice that in this example, both the income effect and the
substitution effect of the price increase worked to reduce the demand for
good 2.
When you have completed this workout, we hope that you will be
able to do the following
• Find Slutsky income effect and substitution effect of a specific price
change if you know the demand function for a good.
• Show the Slutsky income and substitution effects of a price change
96 SLUTSKY EQUATION (Ch. 8) NAME---------- 97

on an indifference curve diagram. blue line parallel to the red line or the black line that you drew before?
• Show the Hicks income and substitution effects of a price change on
an indifference curve diagram.
• Find the Slutsky income and substitution effects for special util­ Bananas
ity functions such as perfect substitutes, perfect complements, and
Cobb-Douglas. 40 ,--...,....-,.--r----r-----r-�--r----,

• Use an indifference-curve diagram to show how the case of a Giffen

good might arise.
30 t---+---t--+--+---t-+--t---1
• Show that the substitution effect of a price increase unambiguously

1--+----t-----------
decreases demand for the good whose price rose.
• Apply income and substitution effects to draw some inferences about 20
behavior.
10 t---+---t--+--+---t-+--t---1
8.1 {O) Gentle Charlie, vegetarian that he is, continues to consume
apples and bananas. His utility function is U(xA, XB) = XAXB. The price
of apples is $1, the price of bananas is $2, and Charlie's income is $40 a
day. The price of bananas suddenly falls to $1. 0 10 20 30 40
Apples

(a) Before the price change, Charlie consumed ___ _ apples and

bananas per day. On the graph below, use black ink to draw (e) The income effect of the fall in the price of bananas on Charlie's
Charlie's original budget line and put the label A on his chosen consump­ demand for bananas is the same as the effect of an (increase, decrease)
tion bundle. in his income of $,____ per day. Does the income

{b) If, after the price change, Charlie's income had changed so that he effect make him consume more bananas or less? ____ How many
could exactly afford his old consumption bundle, his new income would
more or how many less?__________________�
have been ___ With this income and the new prices, Charlie would
(/) Does. the substitution effect of the fall in the price of bananas make
consume ____ apples and ____ bananas. Use red ink to draw
the budget line corresponding to this income and these prices. Label the Charlie consume more apples or less? How many more or
bundle that Charlie would choose at this income and the new prices with
the letter B. less? ____ Does the income effect of the fall in the price of bananas

(c) Does the substitution effect of the fall in the price of bananas make make Charlie consume more apples or less? ____ What is the total
effect of the change in the price of bananas on the demand for apples?
him buy more bananas or less bananas? How many

more or less?_______________________
(d} After the price change, Charlie actually buys ___ apples and
bananas. Use blue ink to draw Charlie's actual budget line
after the price change. Put the label C on the bundle that he actually
chooses after the price change. Draw 3 horizontal lines on your graph, one
from A to the vertical axis, one from B to the vertical axis, and one from
C to the vertical axis. Along the vertical axis, label the income effect, the
substitution effect, and the total effect on the demand for bananas. Is the
8.2 {O) Neville's passion is fine wine. When the prices of all other
goods are fixed at current levels, Neville's demand function for high­
quality claret is q = .02m - 2p, where m is his income, p is the price
of claret (in British pounds), and q is the number of bottles of claret that
he demands. Neville's income is 7,500 pounds, and the price of a bottle
of suitable claret is 30 pounds.
(a) How many bottles of claret will Neville buy?_________
98 SLUTSKY EQUATION (Ch. 8)
(b) If the price of claret rose to 40 pounds, how much income would Neville
have to have in order to be exactly able to afford the amount of claret
and the amount of other goods that he bought before the price change?
At this income, and a price of 40 pounds, how many
bottles would Neville buy?_________________
(c) At his original income of 7,500 and a price of 40, how much claret
would Neville demand?___________________
(d) When the price of claret rose from 30 to 40, the number of bottles
that Neville demanded decreased by ___ The substitution effect (in-
creased, reduced)____ his demand by ____ bottles and the
income effect (increased, reduced) ____ his demand by____
8.3 (0) Note: Do this problem only if you have read the section entitled
"Another Substitution Effect" that describes the "Hicks substitution ef­
fect". Consider the figure below, which shows the budget constraint and
the indifference curves of good King Zog. Zog is in equilibrium with an
income of $300, facing prices Px = $4 and py = $10.
NAME __________ 99
y
40
30 -------------
20 -------------
0 10 20 30 40
X
(a) How much X does Zog consume?______________
(b) If the price of X falls to $2.50, while income and the price of Y stay
constant, how much X will Zog consume?____________
(c) How much income must be taken away from Zog to isolate the Hicksian
income and substitution effects (i.e., to make him just able to afford to
reach his old indifference curve at the new prices)?________
(d} The total effect of the price change is to change consumption from
the point ____ to the poin.,________________
(e) The income effect corresponds to the movement from the point
____ to the point ____ while the substitution effect corresponds
to the movement from the point ____ to the point______
(f) Is X a normal good or an-inferior good? ___________
(g) On the axes below, sketch an Engel curve and a demand curve for
Good X that would be reasonable given the information in the graph
above. Be sure to label the axes on both your graphs.
100 SLUTSKY EQUATION (Ch. 8)
NAME _________ 101

Delphiniums

40

30 t---+--t--t----t--t---+---+---t

20

10 t---+---t--t----t----+---+---t

0 10 20 30 40
Hollyhocks

(c) Now let the price of hollyhocks fall to $3 a unit, while the price of
delphiniums does not change. Draw her new budget line in black ink.
Draw the highest indifference curve that she can now reach with red ink.
Label the point she chooses now as B.

(d} How much would Maude's income have to be after the price of holly­
hocks fell, so that she could just exactly afford her old commodity bundle
A?__________________________

8.4 {O) Maude spends all of her income on delphiniums and hollyhocks.
She thinks that delphiniums and hollyhocks are perfect substitutes; one
delphinium is just as good as one hollyhock. Delphiniums cost $4 a unit
and hollyhocks cost $5 a unit.
(a) If the price of delphiniums decreases to $3.00 a unit, will Maude buy
more of them? ---- What part of the change in consumption is
due to the income effect and what part is due to the substitution effect?
(e) When the price of hollyhocks fell to $3, what part of the change in
Maude's demand was due to the income effect and what part was due to
the substitution effect?__________________
8.5 (1) Suppose that two goods are perfect complements. If the price
of one good changes, what part of the change in demand is due to the
substitution effect, and what part is due to the income effect?____

(b) If the prices of delphiniums and hollyhocks are respectively Pd = $4
and Ph = $5 and if Maude has $120· to spend, draw her budget line in
blue ink. Draw the highest indifference curve that she can attain in red
ink, and label the point that she chooses as A.
8.6 (0) Douglas Cornfield's demand function for good xis x(px ,Py , m) =
2m/5Px · His income is $1,000, the price of x is $5, and the price of y is
$20. If the price of x falls to $4, then his demand for x will change from
to______________________
102 SLUTSKY EQUATION (Ch. 8) NAME __________ 103

(a) If his income were to change at the same time so that he could exactly {a) In January, the price of cigarettes was $1 per pack, while ice cream
afford his old commodity bundle at Px = 4 and Py = 20, what would his cost $2 per pint. Faced with these prices, Mr. C bought 30 pints of ice
cream and 40 packs of cigarettes. Draw Mr. C's January budget line with
new income be? What would be his demand for x at this blue ink and label his January consumption bundle with the letter J.
new level of income, at prices Px = 4 and Py = 20?________
Ice cream

{b} The substitution effect is a change in demand from ____ to 100

The income effect of the price change is a change in demand

90
from ____ to,_____________________
80
(c) On the axes below, use blue ink to draw Douglas Cornfield's budget
line before the price change. Locate the bundle he chooses at these prices
on your graph and label this point A. Use black ink to draw Douglas 70
Cornfield's budget line after the price change. Label his consumption
bundle after the change by B.
60

y
50
80 r---.------.---r-,----.-----.--,r--r---r----,--r---r--,----.--r---,
40
60
30
40 t---+--t---+-+---+--+---+-+--+--+�f--+--+---+-l----1
20
20 i---;--,---1r--t--t---t--t--+--+-+--+--+-+--+--+---I
10

0 40 80 120 160 200 240 280 320

X
0 10 20 30 40 50 60 70 80 90 100
Cigarettes

(d} On the graph above, use black ink to draw a budget line with the new
prices but with an income that just allows Douglas to buy his old bundle,
A. Find the bundle that he would choose with this budget line and label
this bundle C.
8.7 (1) Mr. Consumer allows himself to spend $100 per month on
cigarettes and ice cream. Mr. C's preferences for cigarettes and ice cream
are unaffected by the season of the year.
{b} In February, Mr. C again had $100 to spend and ice cream still cost
?
$2 per pint, but the price of cigarettes rose to �1.25 per pack. Mr.
consumed 30 pints of ice cream and 32 packs of cigarettes. Draw �r. C s
February budget line with red ink and mark his February bundle w ith the
_
letter F. The substitution effect of this price change would make him buy
(less, more, the same amount of) ---- cigarettes and (less, more,

the same amount of) ____ ice cream. Since this is true and the
104 SLUTSKY EQUATION (Ch. 8)
total change in his ice cream consumption was zero, it must be that the
income effect of this price change on his consumption of ice cream makes
him buy (more, less, the same amount of) ____ ice cream. The
income effect of this price change is like the effect of an (increase, decrease)
______ in his income. Therefore the information we have suggests
that ice cream is a(n) (normal, inferior, neutral) ____ good.
(c) In March, Mr. C again had $100 to spend. Ice cream was on sale for $1
per pint. Cigarette prices, meanwhile, increased to $1.50 per pack. Draw
his March budget line with black ink. Is he better off than in January,
worse off, or can you not make such a comparison?______ How
does your answer to the last question change if the price of cigarettes had
increased to $2 per pack?__________________
8.8 (1) This problem continues with the adventures of Mr. Consumer
from the previous problem.
(a) In April, cigarette prices rose to $2 per pack and ice cream was still
on sale for $1 per pint. Mr. Consumer bought 34 packs of cigarettes and
32 pints of ice cream. Draw his April budget line with pencil and label
his April bundle with the letter A. Was he better off or worse off than in
January?______ Was he better off or worse off than in February,
or can't one tell?_____________________
{b) In May, cigarettes stayed at $2 per pack and as the sale on ice cream
ended, the price returned to $2 per pint. On the way to the store, how­
ever, Mr. C found $30 lying in the street. He then had $130 to spend
on cigarettes and ice cream. Draw his May budget with a dashed line.
Without knowing what he purchased, one can determine whether he is
better off than he was in at least one previous month. Which month or
months?_________________________
{c) In fact, Mr. C buys 40 packs of cigarettes and 25 pints of ice cream
in May. Does he satisfy WARP?_______________
8.9 (2) In the last chapter, we studied a problem involving food prices
and consumption in Sweden in 1850 and 1890.
NAME __________ 105
(a) Potato consumption was the same in both years. Real income must
have gone up between 1850 and 1890, since the amount of food sta­
ples purchased, as measured by either the Laspeyres or the Paasche
quantity index, rose. The price of potatoes rose less rapidly than the
price of either meat or milk, and at about the same rate as the price
of grain flour. So real income went up and the price of potatoes
went down relative to other goods. From this information, determine
whether potatoes were most likely a normal or an inferior good. Ex-
plain your answer _____________________
(b) Can one also tell from these data whether it is likely that potatoes were
a Giffen good?_______________________
8.10 (1) Agatha must travel on the Orient Express from Istanbul to
Paris. The distance is 1,500 miles. A traveler can choose to make any
fraction of the journey in a first-class carriage and travel the rest of the
way in a second-class carriage. The price is 10 cents a mile for a second­
class carriage and 20 cents a mile for a first-class carriage. Agatha much
prefers first-class to second-class travel, but because of a misadventure in
an Istanbul bazaar, she has only $200 left with which to buy her tickets.
Luckily, she still has her toothbrush and a suitcase full of cucumber sand­
wiches to eat on the way. Agatha plans to spend her entire $200 on her
tickets for her trip. She will travel first-class as much as she can afford
to, but she must get all the way to Paris, and $200 is not enough money
to get her all the way to Paris in first class.
(a) On the graph below, use red ink to show the locus of combinations
of first- and second-class tickets that Agatha can just afford to purchase
with her $200. Use blue ink to show the locus of combinations of first­
and second-class tickets that are sufficient to carry her the entire distance
from Istanbul to Paris. Locate the combination of first- and second-class
miles that Agatha will choose on your graph and label it A.
106 SLUTSKY EQUATION (Ch. 8) NAME __________ 107

exactly afford the combination of first- and second-class tickets that she
First-class miles would have purchased at the old prices. How much money did she lose?

1600 On the graph you started in the previous problem, use black
ink to draw the locus of combinations of first- and second-class tickets
that she can just afford after discovering her loss. Label the point that
1200 l---+--+--1---+--+--l--+----I she chooses with a C. How many miles will she travel by second class

now? __________________________
800 I---+--+-+--+---+--+--+--
(a) Finally, poor Agatha finds her handbag again. How many miles will
she travel by second class now (assuming she didn't buy any tickets before
400 t---+--+-+--+---+--+--+--1
she found her lost handbag)? ____ When the price of second-class
tickets fell from $.10 to $.05, how much of a change in Agatha's demand
0 400 800 1200 1600 for second-class tickets was due to a substitution effect? ____ How
Second-class miles
much of a change was due to an income effect? __________

(b) Let m1 be the number of miles she travels by first-class coach and m2
be the number of miles she travels by second-class coach. Write down two
equations that you can solve to find the number of miles she chooses to
travel by first-class coach and the number of miles she chooses to travel

by second-class coach.____________________

(c) The number of miles that she travels by second-class coach is,___

(d) Just before she was ready to buy her tickets, the price of second-class
tickets fell to $.05 while the price of first-class tickets remained at $.20.
On the graph that you drew above, use pencil to show the combinations
of first-class and second-class tic�ets that she can afford with her $200
at these prices. On your graph, locate the combination of first-class and
second-class tickets that she would now choose. (Remember, she is going
to travel as much first-class as she can afford to and still make the 1,500
mile trip on $200.) Label this point B. How many miles does she travel by

second class now? ____ (Hint: For an exact solution you will have
to solve two linear equations in two unknowns.) Is second-class travel a

normal good for Agatha? ___ Is it a Giffen good for her?____

8.11 {O} We continue with the adventures of Agatha, from the previous
problem. Just after the price change from $.10 per mile to $.05 per mile
for second-class travel, and just before she had bought any tickets, Agatha
misplaced her handbag. Although she kept most of her money in her sock,
the money she lost was just enough so that at the new prices, she could
Quiz8 NAM.___________ NAME _________ 423

Slutsky Equation (c) reduced his demand by 8.

(d) reduced his demand by 32.

8.1 In Problem 8.1, Charlie's utility function is XAXB- The price of
apples used to be $1 per unit and the price of bananas was $2 per unit.
His income was $40 per day. If the price of apples increased to $1.25 and
the price of bananas fell to $1.25, then in order to be able to just afford
his old bundle, Charlie would have to have a daily income of
(a) 37.50.
(b) 76.
(e) reduced his demand by 18.
8.4 Goods 1 and 2 are perfect complements and a consumer always con­
sumes them in the ratio of 2 units of Good 2 per unit of Good 1. If a
consumer has income 120 and if the price of good 2 changes from 3 to 4,
while the price of good 1 stays at 1, then the income effect of the price
change
(a) is 4 times as strong as the substitution effect.
(b) does not change demand for good 1.

(c) 18.75. (c) accounts for the entire change in demand.

(d) 56.25. (d) is exactly twice as strong as the substitution effect.

(e) 150.
8.2 In Problem 8.1, Charlie's utility function is XAXB. The price of apples
used to be $1 and the price of bananas used to be $2, and his income used
to be $40. If the price of apples increased to 8 and the price of bananas
stayed constant, the substitution effect on Charlie's apple consumption
reduces his consumption by
(a) 17.50 apples.
(e) is 3 times as strong as the substitution effect.
8.5 Suppose that Agatha in Problem 8.10 had $570 to spend on tickets
for her trip. She needs to travel a total of 1500 miles. Suppose that the
price of first-class tickets is $0.50 per mile and the price of second-class
tickets is $0.30 per mile. How many miles will she travel by second class?
(a) 900
(b) 1050

(b) 7 apples. (c) 450

(c) 8.75 apples.
{d) 13.75 apples.
(e) None of the other options are correct.
8.3 Neville, in Problem 8.2, has a friend named Colin. Colin has the same
demand function for claret as Neville, namely q = .02m - 2p, where m
is income and p is price. Colin's income is 6000 and he initially had to
pay a price of 30 per bottle of claret. The price of claret rose to 40. The
substitution effect of the price change
(a) reduced his demand by 20.
{b) increased his demand by 20.
(d) 1000
(e) 300
8.6 In Problem 8.4, Maude thinks delphiniums and hollyhocks are perfect
substitutes, one-for-one. If delphiniums currently cost $5 per unit and
hollyhocks cost $6 per unit, and if the price of delphiniums rises to $9 per
unit,
(a) the income effect of the change in demand for delphiniums will be
bigger than the substitution effect.
(b) there will be no change in the demand for hollyhocks.
(c) the entire change in demand for delphiniums will be due to the sub­
stitution effect.

(d) the fraction 1/4 of the change will be due to the income effect.
(e) the fraction 3/4 of the change will be due to the income effect.